Why This Top Bond Manager Says Yields, While Attractive, Could Still Go Higher

What’s ahead for bond investors? Inflation is high, fueled by the Iran war. Economic growth in the United States is strong, but high oil prices could slow global growth. The landscape presents challenges for central banks. All these are unknowns in global investors’ quest for yield.

Sonal Desai, global chief investment officer for fixed income for Franklin Templeton, is fond of quest narratives—one of her favorite books is The Lord of the Rings. Desai sees how quests change over time: Last year, investors sought safe havens from a global trade war, while this year, they’re navigating thickets of risk. A member of the Barron’s Roundtable, Desai began her career as an IMF economist. She’s been at Franklin Templeton for 17 years, comanaging Franklin Core Plus Bond FKSAX, among other duties. We checked in with Desai about her outlook for the US economy, where US bond yields might be head, and why Japanese bonds look attractive.

Leslie Norton: How were you positioned going into the Middle East war?

Sonal Desai: We were slightly short duration [sensitivity to interest rate changes], not because we had foresight into the war, but driven by my view that inflation had run around 3% for over three years, and I saw no reason for it to come down. We keep hearing that US inflation has been moderating. The numbers don’t show it. Therefore, when the market was pricing in multiple rate cuts this year, that felt really excessive. So we were slightly short duration, and then we went somewhat neutral because we had a solid selloff over the course of the war. And we even, opportunistically, went a little bit long.

Why the US Consumer is Healthy

Norton: Let’s talk about the great American consumer, who you believe is healthier than people think. You recently took issue with the popular thesis about a K-shaped economy, which says that US consumption has split into two arms—one free-spending and affluent pointing up, and the other lower-income and burdened by high inflation and stagnant wages.

Desai: When you’re writing the letter K, one arm moves downward. But I’d argue every cohort is moving upward, albeit at different paces. That pace captures a completely different issue, which is inequality. It’s not the consumer feeling pain; it’s that some cohorts are doing better than others. From a market perspective, you can’t assume that a group of deeply distressed consumers will drive the story of recession. Are consumers employed? By and large, yes. This is probably the single greatest determinant of whether consumption and the economy hold up.

Desai’s US Outlook

Norton: What are your forecasts for the US economy?

Desai: This year, headline inflation could well be closer to 4% than today. [Today it is 3.8%.] I think 4% will create problems for the Fed, but you need to see a bit more than 4% for the Fed to reverse itself. For the Fed to hike, we’d need to start seeing clear evidence that oil prices will remain elevated for longer and that headline inflation approaches 5%.

Every 10% increase in oil prices increases inflation by an estimated 0.25-0.35 percentage points. We entered this war with oil prices at $60-$65 a barrel. Even if the war ended tomorrow, we’ll close the year with oil prices significantly closer to $80 than $60. The damage has been done, inventories have been run down, demand will be higher, so [inflation in the] high 3s is baked in this year.

For GDP, we’re getting a massive amount of impact from capex and lots of fiscal stimulus from tax cuts. That’s why, despite higher inflation, consumers continue to spend. So despite everything we’re seeing, GDP growth will be closer to 3% than 2%. That’s why I have a relatively benign view of credit quality.

Norton: What will the Fed do?

Desai: We have a rate hike priced in this year. We’ll see higher inflation for a few months. Will we see the second-round effects come through, or will the Fed be patient? I don’t anticipate that under Kevin Warsh, dramatic things will happen to the Fed balance sheet on Day One, but we’ll probably see the Fed move back to more orthodox monetary policy. That’s not a bad thing if the Fed stops intervening and distorting the long end of the yield curve, as it has time and again since the global financial crisis.

Norton: What does that mean for US bonds?

Desai: I’ve been on record for three years that rates need to be higher (and that for nominal neutral Fed funds, it’s probably closer to 4% or a bit higher) than the Fed’s 3%. So I don’t find the 10-year yield at the 4.5% level particularly surprising.

Norton: When would you be buying?

Desai: If the 10-year yield gets to the 4.75%-5.00% level without anything else dramatic happening with inflation or the fiscal [position], you can start going long duration. That’s not because you’ll get massive appreciation from your bonds, but you are going to clip a nice coupon. In credit, we remain invested—we’re not underweight, but we’re not getting over our skis.

The credit story has two parts. On one hand, spreads are extremely tight. On the other hand, yields are attractive. So put those two factors together, and I’d need to see the economy weakening markedly to start saying that default rates will pick up a lot. And I’m not very pessimistic about the US economy.

Outlook for the Dollar

Norton: Are we at fair value for the dollar today?

Desai: Let’s look at the Eurozone and Japan. Against the euro, the dollar is at its fair value, at $1.16. When the euro launched in 2000, its fair value was $1.18. Today, the fair value for the euro is probably a bit weaker. The Japanese yen is massively undervalued against all comers. Twenty years ago, I remember being stunned at how expensive everything was. Now, I’m equally stunned at the opposite.

Why Desai Likes Japan

Norton: Let’s hear more about Japan.

Desai: The 30-year Japanese bond yield is 4%. I’m not suggesting you jump into Japanese 30-year bonds, or go as far out; there’s a lot of volatility. But as a US-based investor, if you neutralize the exchange rate, you’re getting a 7% return. Now, a 30-35-basis-point selloff would wipe out your 7%. But Japan is becoming a genuinely investable bond space, which it hasn’t been in decades.

We do need the Bank of Japan to start becoming serious about inflation. It needs to raise interest rates. I’m not an equity person, but both equities and fixed income in Japan are interesting. The Japanese fiscal backdrop is superior to that of the US. They’re running a primary deficit of just something like 1.5%, relative to our 4.0%. Japan will be a winner in productivity growth. They will be much earlier adopters of AI than Europe. We’re trying to find the exact point where we think we would take advantage of both an extremely steep yield curve and the roll down [the capital gain created by the decline in a bond’s yield as it approaches maturity].

Norton: Where else are you finding opportunities, and what are you avoiding?

Desai: We’re shunning US long duration at current valuations. In Europe, historically, the European Central Bank has erred in the direction of being overly hawkish. I wouldn’t go near France, but in Germany, Spain, and even potentially the UK, there are opportunities. There remain quite good fundamentals in the US, so in a lot of areas, such as corporates, we prefer the US.

In emerging markets, we’re looking to opportunistically add exposure. We’re shunning energy importers—they’ll go through a difficult period. Well-behaved emerging markets are attractive. Emerging markets, by and large, don’t have the luxury that the developed world has of accommodating a price shock by cutting taxes or giving subsidies. Eventually, EM can get to a space where it can cut rates. Not yet. We’re looking at higher-yielding local and hard currency EM debt, as it still provides interesting opportunities. Countries in Latin America are relatively immune to the current Middle East war.

I’d also recommend that people in money market accounts get into some fixed-income funds. They’re not going to get massive capital appreciation, but they will clip a very healthy coupon. If they’re scared, they should start with ultrashort, which will increase income and keep liquidity. And after that, go into a well-diversified income generator. As I said, fair value for 10-year Treasuries is 4.75% or a bit higher.